Asset-backed digital financial products: a financial instrument of the future or a passing fad?

April 19, 2019

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The advent of blockchain has undoubtedly marked the beginning of a new financial technology revolution and has begun to reshape traditional financial markets. Both its supporters and its opponents cannot deny that there is no going back to the times before initial coin offerings (ICOs) and security token offertings (STOs).

A lot of hopes are pinned on asset-backed financial instruments and let us explain to you what they are and why you should care.

From ICO heat to crypto winter

Blockchain-based digital financial products today go beyond once marginal cryptocurrencies. Today they also include the so called utility and security tokens, as well as hybrid versions of these two types of financial instruments.

Certain types of utility tokens have given blockchain a bad rap because they were involved in numerous failed ICOs which had attracted billions of dollars and burned many unsuspecting retail investors with no real experience in the financial world. So what initially started as an ICO craze was quickly followed by a crypto winter.

The bad news is that a substantial number of failed ICOs has scarred many potential investors. The good news is that the scare has prompted a significant shift in how regulators see blockchain-based financial instruments. The most forward-thinking regulators see this change in financial market participants’ mindset as an opportunity, not a threat. Luxembourg, for example, in February passed a law facilitating the use of blockchain technology in financial services. The document has granted transactions made with blockchain technology the same legal status and protection as those made through traditional means.

Security tokens vs utility tokens

So how does the new type of token – security token – differ from a utility token?

Utility token is essentially a stand-in for companies’ products or services. Think about it as a digital voucher or coupon, or, as Bloomberg put it, a Starbucks gift card. The card is not a security because by purchasing it you are not making a financial investment with the expectation of profit but instead putting money into an expectation of receiving a service, such as purchasing a cup of coffee.

A security token is a digital financial instrument that is backed by real-life tangible assets, such as art, real estate, tokenized equity shares. They are virtual versions of securities that for centuries have been the backbone of traditional financial markets. This makes them a bridge between the incumbent financial instruments and blockchained-based technology advancements. STOs are definitely here to stay with some predicting that security tokens will bring 10% of global GDP – roughly $8 trillion – into the blockchain ecosystem by 2024.

While utility tokens and security tokens often start off as different as chalk and cheese, over time the boundaries between the two can blur together which complicates regulation of these instruments. In the US, for example, the Securities and Exchanges Commission (SEC) uses the so called Howey test to determine whether a financial instrument can be considered “an investment contract,” or security.

Under the Howey Test, a transaction qualifies as an investment contract if:

It is an investment of money;

With an expectation of profits from the investment;

In a common enterprise;

Any profit comes from others’ efforts.

Legal battles have been won and lost over practical application of the Howey test to ICOs and various tokens. But the jury is still out on a lot of these cases and regulation varies from country to country outside of the US.

Venture capital: a new class of digital financial instruments

Among the chaos, new promising asset-backed digital financial instruments emerge in various countries. Tokenizing artwork, real estate and shares of publicly traded companies is no longer new. But tokenizing venture capital takes tokens to a whole new level. Tokenized venture capital as a new asset class offers a unique opportunity to VC firms, entrepreneurs and a broad pool of institutional and retail investors to invest into a new-generation digital financial instrument.

The idea behind VC tokenization is simple. After a special assessment process, VC firms’ startup portfolios get split into multitudes of pieces. This allows investors an opportunity for fractional ownership in these portfolios and, by proxy, the next Uber, Pinterest or Airbnb before they go public. This helps VCs unlock the much needed liquidity that they could use to invest in more startups and promotes entrepreneurship through the distribution of this liquidity among new startups. This also democratizes startup investing making it available and accessible to all.

Performed on the blockchain, tokenization offers such unique benefits to investors as immutability, safety and security of transactions, custodial support, speed and 24/7 operations. Distributed ledger technology often used by startups can reinvent VC investing by putting it on its head. Startups that tokenize VC portfolios have a unique opportunity to help VCs, a very powerful concept that can make the VC and startup ecosystem whole and shift the power dynamic between the two.

And what better way to foster economic growth and encourage new technology developments than through a combination of VC firms’ expertise, startup vigor and blockchain? This is what the new era of venture capital will look like.

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